Monday, January 29, 2007

In my previous post, I was ranting about the global nature of carbon emissions and how local initiatives to limit carbon emissions and set environmental standards can seem so futile in the grand scheme of things. This means that local carbon emitting regulations abiding by the “Kyoto standards”, like those passed in California, can have limited direct effects on the global environment. (More on the indirect effects in a later post.) To be truly effective, such regulatory measures need to be global. The problem us that, as shown in Kyoto, it is quasi-impossible to impose global regulations limiting carbon emissions.

(Briefly, as background, here is why such a top-down negotiated approach is difficult: Mature economies like the US are moving to services, and emitting relatively less CO2 over time, and fast growing countries like China are poised to emit more and more CO2 as they grow into industrial powerhouses. So it is arguably ‘unfair’ for the ‘developed world’ to impose limits on the emissions of the developing world and thus impede their growth and development. But it would be unfair on the ‘developed world’ to be lax on the ‘developing world’ while restricting their own emissions. Thus the impasse at the negotiating table.)

But even if we could come to a Kyoto-like globally negotiated ‘fair’ amount of carbon each country could emit, the mere notion of some international organization or group of politicians dictating how much carbon each country can be allotted gives my Chicago-sensitized mind the creeps. Here is an analogy to make my point:

Imagine if we allowed an international group of politicians to decide how we should allocate capital (i.e. investment $$) around the world. Say all the investment dollars in the world went to one big pot and the United Nations was allowed to decide how to allocate it to all the countries in the world. Sure you can come up with formulas, and sure you can hope to come to a political solution for allocating the capital. But at the end of the day, you are just going to end up with a terribly inequitable, de-motivating and inefficient system – if you do a great job, the best you can hope for is to become just a little more efficient than the Soviet central planning bureau! :)

The Cap and Trade Schemes at least try to impose some form of ‘market’ mechanism within the carbon industry. And they do this at the cost of generally ignoring the global nature of the environment (because they would have difficulty imposing such a scheme on the Chinas of the world.)

But even within their more limited local scope, Cap and Trade Schemes have proven difficult to implement in practice. The problem with ‘Cap and Trade’ is not in the Trading part – that is the ‘market mechanism’ – it is in the “Cap” part. To-date, the political process has set the emissions caps that are later traded in the market, so the market mechanism is built on a corruptible and non-market foundation. The European Emissions Trading Scheme showed the kinds of problems this root cause can create. Here is a description from The Economist (unfortunately behind a firewall):

Yet even while lauded as a model for others, the [Emissions Trading] scheme is failing at home... For political reasons, the EU left the power of allocation to national governments. As a result, what should have been an exercise in setting rules for a new market became a matter of horsetrading about pollution limits, with powerful companies lobbying for the largest possible allowances.

Last year, governments gave away (ie, did not sell) pollution permits that amounted to more than the pollution companies were actually spewing forth. That risks making the scheme pointless. The European Commission is now reviewing proposals for allocations in 2008-12…

Lax allocations do more than just fail to cut greenhouse gases (bad enough, you might think, given that this is the main point of the scheme). They also damage the market. When it became clear, in April, that most allocations were larger than actual emissions, the price of carbon halved almost overnight. Some volatility is probably inevitable in a new market, but when combined with irresponsible behaviour by governments it hardly encourages people to enter the emissions-trading business.

It gets worse. The plunging price sends a market signal to developing countries that have installed pollution controls partly so that they could sell the resulting “pollution credits” for a nice profit. That no longer looks like a good idea.

Similarly, some countries (Germany, France and Poland) have scattered permits around like confetti while a few (Britain, Ireland and Spain) have been sparing because they want to cut emissions. Companies in the second group are buying permits issued in the first, so the market is transferring resources from places that are using the scheme to curb pollution to those that are not. Brilliant.

The solution around these problems (as advocated by the Economist, as well as the Obama-McCain bills) is to auction the permits, rather than allocate emissions caps to each industry. But even if such bills become law, the risk is that the capping will become distorted as it passes through the political process.

To illustrate the problem, I’ve been thinking about what a Cap and Trade scheme might look like if applied to another industry. If we decided to implement a cap and trade scheme to address internet bandwidth and net neutrality for example, what would it look like? First, we would need to figure out how much bandwidth each company is using today, and we would cap bandwidth usage at those levels. We would limit each company’s future use of internet bandwidth to that amount of traffic. If anyone wanted more bandwidth, they would have to buy it on the ‘market’. Even if we ‘auctioned’ all the rights to the bandwidth, rich cash cow incumbents (like the telcos) could afford it and create a market in the rights to the traffic. We could claim it is a “market based system”, but if a new company wanted to deliver new web based services (say like User Generated Video), they would have to buy the bandwidth rights from the incumbents! Think about what that would do to innovation.

Of course, the analogy is far from perfect. I am trying to draw on extreme example to make a point. My next post will be far more positive.:)